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8/3/2019 India Outlook - Nomura
1/106
Rolling back the clouds
Macro risks near term butlargely discounted, see muchimproved second half
We expect growth in India to stay slow, inflation to slowly ease, therupee to be weak near term and rate cuts to happen with a lag.
In this environment, we prefer banks and exporters such as IT and
pharma to capital goods and autos. We are also underweight theconsumer sector. We would play the investment cycle throughcement rather than infrastructure.
Our top picks are SBI and Axis Bank on a more benign rate
environment, and exporters like Infosys and Lupin on the weak
rupee. We like Power Grids regulated return profile.Key analysis in this anchor report includes:
Outlook for economic growth and the investment cycle Why we expect the rate-cutting cycle to be back-ended in 2012 if
further rupee pressure disrupts the fall in inflation momentum
A look at the near-term currency headwinds due to concerns aboutcapital flows and Europe
How valuations stack up historically. We see 15-20% market upsidethrough the year
EQUITY RESEARCH
A
NCHOR
REPORT
January 13, 2012
Research analystsIndia Strategy
Prabhat Awasthi - NFASL
[email protected]+91 22 4037 4180
Nipun Prem - NSFSPL
[email protected]+91 22 4037 5030
Sanjay Kadam - NFASL
[email protected]+91 22 4037 4187
And the India Research Team
See Appendix A-1 for analystcertification, importantdisclosures and the status ofnon-US analysts.
India outlook 2012
8/3/2019 India Outlook - Nomura
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India outlook 2012EQUITY STRATEGY
EQUITY RESEARCH
ANCHOR REPORT: Rolling back the clouds
Macro risks near term butlargely discounted, see muchimproved second half
January 13, 2012
Macro risks near term, but largely discounted; we see a much
improved 2H
Taking stock of Indias macroeconomic variables today makes fordepressing reading. Policy inaction, rising rates and an adverse global
environment have taken a toll on growth. A fragile external account hascaused the rupee much distress, particularly against a backdrop of
volatile global risk sentiment. Politics and policy continue to disappointand populism has elevated the fiscal deficit.
We start 2012 against this backdrop. The bad news is that not muchis likely to change in the 1H of this year. The sharp depreciation of
the rupee on global cues has hijacked inflation. India has to fund its highcurrent account deficit; there are also large debt repayments to contend
with. This is likely to create growth and currency headwinds as capitalinflows are constrained by the ongoing European crisis.
The good news is that these headwinds are temporary and arelikely to dissipate in 2H12. Capital constraints should ease as slower
growth and a weaker rupee rein-in the current account and debtrepayments run their course. Cooler growth and range-bound global
commodity prices are likely to accelerate the downtrend of inflation. The
rupee could well appreciate on these cues. Growth may well remainsubpar as the impact of rate cuts lifts the economy with a lag. However,
we believe India will continue to enjoy high growth differentials.
With the market earnings multiple at a 23% discount to its 5-yearaverage, market valuations are fairly pricing in the negativescenario, in our view. Growth plays and domestic cyclicals have been
punished, while strong cash flows and consumer-facing companies havebeen rewarded. There could be some risk to earnings, but no more than
5%, we think.
We acknowledge that the positive dynamics could well take about
six months to kick in. However, we could well move towards a more
benign rate environment in this period. The backdrop for equities in the
1H12 is likely to be slowing growth, gradually falling inflation, weakrupee and a peaking rates cycle. We prefer banks and exporters (IT
and pharma). We are underweight capital goods, infra &construction, autos and global cyclicals.
Fig. 1: Stocks for Action
Source: Nomura research ricin asof 6 Jan
Anchor themes
The backdrop for equities in1H12 would be slowing growth,gradually falling inflation, a
weak rupee and an improvingrate environment. Our key stockpicks are the rate cyclicals,SBIN and AXSB, and exporters,INFO and LPC. We also likePWGR as a defensiveregulated utility.
Research analysts
India Strategy
Prabhat Awasthi - NFASL
+91 22 4037 4180
Nipun Prem - NSFSPL
[email protected]+91 22 4037 5030
Sanjay Kadam - NFASL
[email protected]+91 22 4037 4187
And the India Research Team
Stock Rating Price TP Upside/Downside (%)
State bank of India (SBIN IN) Buy 1,672.8 2,400 43
Axis Bank (AXSB IN) Buy 853.5 1,400 64
Infosys Technologies (INFO IN) Buy 2,832.2 3,300 17
Lupin (LPC IN) Buy 442.9 576 30
Power Grid (PWGR IN) Buy 99.8 120 20
See Appendix A-1 for analystcertification, importantdisclosures and the status ofnon-US analysts.
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Nomura | India outlook 2012 January 13, 2012
2
Contents
4 Executive summary
6 Sector strategy
7 Growth has been a casualty; we expect a couple of quarters of tepidgrowth before recovery
12 Digging deeper into investments
17 The rupee: capital flows and eurozone concerns
23 Inflation: Less of a risk this year provided the rupee does not weakenfurther
28 Rates cuts to likely be back-loaded if further rupee pressure disruptsfall in inflation momentum
29 Valuations not demanding and are pricing in a significant cut toearnings, but waiting for triggers
31 Earnings expect some downside to FY13F earnings
34 Policy and political economy a clouded picture
36 Key themes
38 Long-only basket
39 APPENDIX
45 Economics
45 Policy holds the key
47 Sector outlooks
49 Autos & auto parts
51 Banks
53 Cement
55 Coal
57 Consumer
59 Infrastructure
61 IT services
Also see our Anchor Report: Asia
Pacific outlook 2012 So the world
doesn't end after all(5 December, 2011)
http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=8/3/2019 India Outlook - Nomura
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Nomura | India outlook 2012 January 13, 2012
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64 Metals & mining
66 Oil & gas/chemicals
68 Pharmaceuticals
70 Power & utilities
72 Property
74 Telecoms
77 Company profiles
79 Axis Bank
83 Infosys
86 Lupin
90 Power Grid Corp of India
93 State Bank of India
99 Appendix A-1
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Executive summaryIndia today finds itself smack in the middle of a whirlpool of pessimism. Taking stock of
Indias macroeconomic variables makes for depressing reading. Policy inaction, rising
rates and a difficult global environment have taken a toll on growth. Meanwhile, a fragile
external account has caused the rupee much distress in the backdrop of volatile global
risk sentiment. Politics and policy continue to disappoint and populism has elevated
fiscal deficit concerns.
Its against this backdrop that we enter into 2012. The bad news is that not much is likelyto change in the first half of this year. The good news is that these headwinds are
temporary and would dissipate in the second half of the year.
The incremental deterioration in Indias macro fundamentals was triggered by the
sudden global risk flare-up late last year following the sovereign downgrade of the US
and rising deleveraging fears for eurozone banks. The resulting sharp depreciation of the
rupee has hijacked inflation and arrested its otherwise declining momentum. This has
pushed back the rate-cutting cycle, which we think would be back-loaded in 2012. The
RBI would find it difficult to justify a rate cut unless inflation is reined in to more
comfortable levels, probably closer to 7%.
However, inflation should be less of a concern for markets this year, in our view. As the
economy slows down, pressure on labour markets should recede and wage increases
should slow. A strong US dollar and a slow-moving global economy are likely to keep
global commodity prices in check. This should aid the decline of inflation further.
Gradually declining inflation and continuing growth concerns would likely keep bond
yields in benign territory in the first-half of the year.
India has to fund its high current account deficit, which has been made worse by a switch
in allocation of household savings into valuables. Unlike the last crisis in 2008, there are
also large debt repayments to contend with on account of private borrowings raised in
2006-07. This is likely to create growth and currency headwinds as capital inflows are
constrained by the ongoing European crisis. After its sharp underperformance, we
reckon the rupee is probably undervalued at current levels. This should gradually
improve India's current account with a lag while concerns on debt repayments diminish
through the year. We see this happening in 2H12.
Growth would continue to face headwinds. The lagged effects of past tightening and tight
liquidity are likely to continue to play out in 1H12. Private consumption is starting to slow,
government spending power is muted and investment cycle is adjusting to slower growth
amidst uncertainties on external demand. Market sentiment is likely to take its cue from
weakness in industrial production growth in 1HCY11F. However, India should continue to
enjoy its high growth differentials vs. developed economies in a weak global growth
scenario expected this year.
However, market valuations are no longer expensive at current levels and are pricing in
a significant cut in earnings and further downside to economic growth. The market
earnings multiple would start to look more attractive as inflation eases and bond yields
fall.
We expect FY13F Sensex earnings growth of c.10-12%. We believe the trajectory for
earnings through the year would likely slow. Earnings could see some more risk as the
economy feels the lagged impact of the rate tightening cycle. Margin pressures could
persist in first-half from lagged effects of rate tightening and high commodity prices.
However, a weak outlook for global commodity prices would subsequently be a tailwind
for corporate margins provided the rupee does not depreciate further from here. As well,
base effect tailwinds will come into play in the second half of the year.
So how do we play this? The backdrop for equities in the first-half of the year would be
slowing growth, gradually falling inflation, weak rupee and peaking rates cycle. We prefer
banks and exporters (IT and pharma). Given concerns on the capex cycle, are
underweight domestic cyclicals capital goods and infra & construction. We would play
Indias investment cycle through the cement sector rather than capital goods. Slowing
growth would lead to weak government finances which would mean that its ability to
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5
spend incrementally would be compromised. In our opinion, the consumer cannot expect
too many freebies from the government from here on in.
We see little hope for big-bang reforms during the tenure of the present government.
However, the outcome of the upcoming state elections in the first-half could shape policy
expectations and could very well lead to a positive surprise.
We expect the market to rise 15-20% from here and take cues from the likely
improvement in the macroeconomic environment in the second half of the year. Further
deterioration in Europe poses a key risk. Exaggerated declines in the market could
provide a good buying opportunity.
Fig. 2: Key themes
Source: Nomura Research
Key theme Comments
Growth We expect continuing headwinds to growth. Tight systemic liquidity and adverse base effects are likely to lead to weak industrial growth
numbers in 1H12. Private consumption is starting to slow, government spending power is muted and investment cycle is adjusting to slower
growth and uncertainties on external demand. Market sentiment is likely to take its cue from weakness in IIP growth in 1HCY11F. However,
India should continue to enjoy its high growth differentials vs. developed economies in a weak global growth scenario expected this year.
Inflation While inflation momentum has come off its highs, the rupee's depreciation would mean that the fall of inflation momentum would be slower.
As the economy slows down pressure on labour markets should recede and wage increases should slow. We expect more tapering off in
2HCY12F on base effects. Inflation should become less of risk to markets this year. As well, a strong US dollar and a slow-moving global
economy are likely to keep global commodity prices in check this year. A prospective improvement in the current account would be a tailwind
for the rupee.
Earnings We expect FY13F Sensex earnings growth of c.10-12%. We believe the trajectory for earnings in 2012 would likely be slow. Earnings could
see some more risk as the economy feels the lagged impact of the rate tightening cycle. We see margin pressures in 1H12 from lagged
effects of rate tightening and high commodity prices. Weak outlook for global commodity prices in 2012 would subsequently be a tailwind for
corporate margins, provided the rupee does not depreciate further from here. In addition, base effect tailwinds are likely to come into play in
2H12.
Investment cycle/capex We expect some disappointment in the short- to medium term. We see several obstacles to the capex cycle, despite strength in demand.
With a few large sectors driving organised manufacturing capex, the investment outlook for these key capex-driving sectors remains muted
next year. Meanwhile, the unorganised manufacturing sectors suffers the most in an environment of very tight liquidity and high rates. We
believe that new order inflows would remain poor as the economy adjusts to a lower growth path and government spending power remains
limited due to poor finances.
Policy We expect monetary policy to start easing, albeit slowly. The downward trajectory of inflation momentum has been pushed back by rupee
depreciation. The external environment remains a key determinant of the RBI's ability to respond to slower growth. We expect rate cuts to be
back-loaded this year. Key risks are further rupee weakness arising from eurozone deleveraging concerns; a cost-push shock (higher oil
prices on geopolitical risks); and fiscal profligacy. We do not expect positive developments on reforms to be a catalyst for the market nextyear. However, the outcome in the upcoming state elections could prove important in shaping policy.
Liquidity We expect liquidity to remain tight in the near term, particulary due to external account pressures. Funding costs for corporates are likely to
remain high in the next six months before starting to come off. Bank NIMs may continue to do fine due to lack of overseas funding and
sigificant forex debt repayments which would likely be funded by India banks.
Rates Rate cuts are likely to be back-loaded this year: While inflation should be on the decline, its fall has been tempered by the weakness in rupee.
Hence, it would take much longer for the RBI to be comfortable enough with inflation numbers before going in for a rate cut even as growth
slows down further. We reckon that a fall in inflation below 7% or so could trigger policy actionunlikely to be reached in 1H12, we
reckonunless the RBI deems growth headwinds to have intensified enough to warrant a cut with inflation at 6-7%. Significant rate cuts are
also unlikely in 1H12 because external sector pressures and concerns on capital flows would be elevated. A cut would reduce Indias rate
differentials at a time when the RBI is taking several measures to attract capital inflows.
Rupee The rupee is l ikely to remain under some pressure over six months on account of large debt repayments on capital account and lack of
external funding on account of the European situation. The rupee is probably undervalued at current levels and this should gradually improveIndia's current account while concerns on debt repayments diminish through the year. Falling inflation should also help support India's high
rate differentials. This should lead to a rally in the currency later in the year. Key risks to this view are from oil prices and disorderly defaults in
the European economy.
Valuation Valuations are no longer expensive and are pricing in a significant cut in earnings, further downside to economic growth and an elevated rate
cycle. The market earnings multiple would start to look more attractive as inflation eases and bond yields fall. We see limited downside to the
markets. However, there is also limited visibility the in near-term; the 2H of the year looks better. We do note that the market would continue
to lack short-term triggers.
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Sector strategy
Fig. 3: Sector strategy
Note: Relative weightings for sector allocation given here are different from absolute sector ratings given in the sector sections of this report
(*) Relative to BSE100 index
Source: Nomura research
Sector Headwinds Tailwinds
Relative weighting
for asset
allocation (*) Strategy comments
Autos Expect lower volume growth due to slowdown in
economic growth and lower customer demand. We
expect the growth to decline substantailly for two
wheelers and commercial vehicles, while cars mayrecover after a flat year. Margins will come under
pressure due to fight for market share in low growth
environment.
Fall in raw material costs could lead to margin
support. Decline in interest rates will be a minor
positive as well.
UNDERWEIGHT Slow growth, rising
competition
Banks 1) Ri sing incrementa l delinquenc ies and credi t
costs; 2) lower-than-anticipated loan growth for
FY13F; 3) domestic & global macro uncertainty;
4) delayed onset of interest rate cuts
1) accelerated interest rate cuts 2) lower than
forecasted delinquencies 3) decreasing global risk
aversion
OVERWEIGHT NIMs pro tected , ra te cycle
peaked, valuations cheap,
possible benefits from
refinaning of foreign debt
payments
Cement Low activity in the infra and real estate space
continuing to impact demand for cement. High level
of capacities leading to low level of capacity
utilization and need to maintain production
discipline
Cement producers are able to maintain pricing at
levels where they are seeing reasonable
profitability and mid-cycle returns. Easing political
situation in key southern states could improve
demand growth
OVERWEIGHT Strong cash f lows, pric ing
discipline
Consumer One of the big headwinds for the consumer sector
is likely to be the depreciating rupee. This will take
a toll on profitability of companies like Asian Paints
(APNT IN), Hindustan Unilever (HUVR IN), Nestle(NEST IN) and GCPL (GCPL IN). Another big
headwind is likely to be slow down in discretionary
spends and is likely to impact companies like Titan
(TTAN IN).
Most companies are now focusing on expanding
rural footprint through enhanced distribution which
could boost growth. Slowing food inflation will also
be beneficial for consumer companies.
UNDERWEIGHT Consumer slowdown,
expensive valuations
Electrical
Equipment
Margin pressure from rising foreign and domestic
competition and higher raw material and wage
costs; shortages of labour; weak recovery in
industrial capex
Power-related capex upside; T&D equipment
makers to likely witness pickup in orders
UNDERWEIGHT Slowing investment cycle,
fuel shortages
Infra &
Construction
Weakness in investment cycle; land acquisition,
environmental and policy issues; labour shortages
Roads and power sector order flow; Interest rate
cuts
UNDERWEIGHT Slowing investment cycle,
government finances weak
IT Services Moderation in demand led by client decision making
inertia and macro economic uncertainty.
Rupee depreciation benefits to margin and EPS
(Tier-1 IT have EPS sensitivity of 1.4-2.3% for
every 1% INR depreciation). Long term trends of
consolidation, offshore penetration, productisation
and pervasiveness of technology favourable for tier
1 IT which will aid them to gain market shareagainst MNCs.
OVERWEIGHT Exporter , US strength
Metals &
Mining
Global macro concerns: European debt worries,
China slowdown - these fears have kept restocking
slow despite low inventory levels and hence metal
prices have not recovered which is usual during
fourth quarter.
Domestic demand beginning to improve, weak
INR, volume-led earnings growth led by completion
of expansion plan - Indian demand seems to be
improving and net imports have begun to rise
which is good news for expansions expected in the
near term.
UNDERWEIGHT Global growth concerns
Oil & Gas High oil pr ice; Continued policy paralysis and
continued impasse on key contentious issues
Oil price downside; New LNG capacity coming on-
stream; positive govt actions to bring reforms
UNDERWEIGHT Global growth concerns,
policy issues
Pharma Imposition of new pricing control regime in India as
proposed in the draft policy. The move shall be
negative particularly for MNCs.
Depreciation of INR against the export currencies
particularly against the USD is a net positive for
the sector. Also the sector shall present
unprecedented product opportunities in the US
market, which can present upsides to current
forecasts.
OVERWEIGHT Exporter , patent expiries in
the US
Power Power: [1] Intensifying fuel risk (sourcing & pricing)leading to project delays / low PLF, [2] SEB
financials remain precarious, payment timelines
lengthening. Coal: Delays in project clearances,
ambiguity over price revision
[1] Recent policy diktats on retail tariff revision toimprove SEB financials (albeit in the medium
term), in turn provide pricing flexibilty of domestic
coal, [2] 2012 policy offings to boost l onger-term
fuel security: coal block auctions, policy on sale of
captive coal
OVERW EIGHT Regulated return
Real Estate Unaffordable pricing leading to lower volumes. Low
volumes and execution issues are leading to cash
flow problems for developers who are leveraged
Likely reduction in mortgage rates and
improvement in the approvals situation could lead
to improving volumes while any price correction
could boost volumes further
OVERW EI GHT Ra te cyclical, likely
household switch back into
real estate
Telcos Regulations; volatile competition; questions over
data economics (substitution impact)
Revenue and margin Impact of recent voice price
hikes; data upside
OVERW EI GHT Strong cas h f lo ws,
reasonable valuations
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Growth has been a casualty; we expect a couple of quartersof tepid growth before recovery
Growth pessimism: India today finds itself smack in the middle of a whirlpool of
pessimism. And this overwhelmingly negative sentiment is not without reason growth
has come off, inflation and interest rates remain high amidst tight liquidity, corporate
earnings have taken a knock, fiscal concerns are high, government decision making has
been stymied and the legislature remains hamstrung; the reforms process has largely
disappointed and the rupee has lost significant ground.
Slowdown in growth momentum has occurred due to a combination of endogenous and
exogenous factors: (1) aggressive tightening by the RBI (intentional and endogenous)
and tight systemic liquidity in the face of high inflation; (2) weak global growth and poor
global risk appetite (exogenous) and (3) supply-side disruptions in key factors of
production problems related to land acquisition, environmental clearances, coal-
supply linkages and mining bans arising out of delays in government decision-making
and policy (endogenous).
Indias growth differentials are stabilising at just below pre-crisis levels: Before we
discuss further, it is vital that the ongoing slowdown in India is juxtaposed with that in
other global economies. The two exhibits below show for the pre-and post crisis periods
the evolution of absolute GDP growth for major economies and Indias relative growthdifferentials. Two key conclusions stand out: (1) at an aggregate level, the growth
experience of these economies has broadly been similar to Indias growth rates
dropped post crisis, recovered after a few quarters (strong base effects) and have been
gently falling over the past year-and-a-half.
Fig. 4: Despite the pessimism surrounding Indias growth, the economy still enjoyshigh absolute growth rates in a weak global growth environment
Source: Bloomberg, Nomura research
(2) Indias growth differentials rose in the period following the crisis until mid-2009 asIndias economic performance was supported by strong momentum in domestic
consumption; differentials declined subsequently until mid-2010 (stronger base effects
boosted growth rates of regions that were hit harder during the crisis) and have since
stabilised at just slightly below pre-crisis levels.
(20)
(15)
(10)
(5)
0
5
10
15
20
Jun-04
Sep-04
Dec-04
Mar-05
Jun-05
Sep-05
Dec-05
Mar-06
Jun-06
Sep-06
Dec-06
Mar-07
Jun-07
Sep-07
Dec-07
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
Jun-09
Sep-09
Dec-09
Mar-10
Jun-10
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
GDP growth rates
India China BrazilRussia US JapanGermany UK EU
(%)
Growth pessimism is at a peak
Growth has taken a hit on tight
monetary conditions, weak
global macro, ineffectual policy
and supply-side disruptions
However, Indias growthdifferentials remain high and are
stabilising just short of pre-crisis
levels
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Fig. 5: Indias growth differentials have since stabilized at just slightly below pre-crisislevels
Source: Bloomberg, Nomura research
The growth slowdown has caused market multiples to contract: While growth (and
its expectations) have fallen globally, the significant underperformance of Indian equities
over the past year reflects investor concerns on endogenous reasons for Indias growthslowdown excessive tightening of policy rates in the face of high inflation (although,
Indias WPI basket is largely driven by global commodity prices), supply-side disruptions
in key factors of production, and overall negative sentiment resulting from high-profile
cases of graft that have afflicted the government and the policy paralysis that ensued. As
the Exhibit below shows, the loss of confidence in Indias growth story has been reflected
in the contraction of the markets earnings multiple.
Fig. 6: The decline in growth has been reflected in the de-rating of the market multiple
Source: Bloomberg, Nomura research
As the exhibit below shows, the combination of growth concerns, elevated inflation,
subpar political governance, and a much-depreciated rupee have driven the significant
underperformance of Indian equities compared to regional peers last year.
-10
-5
0
5
10
15
20
25
Jun-04
Sep-04
Dec-04
Mar-05
Jun-05
Sep-05
Dec-05
Mar-06
Jun-06
Sep-06
Dec-06
Mar-07
Jun-07
Sep-07
Dec-07
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
Jun-09
Sep-09
Dec-09
Mar-10
Jun-10
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
Average China BrazilRussia US JapanGermany UK EU
(%)
(80)
(60)
(40)
(20)
-
20
40
6080
100
(10)
(5)
0
5
10
15
20
Jan-00
May-00
Sep-00
Jan-01
May-01
Sep-01
Jan-02
May-02
Sep-02
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
Jan-07
May-07
Sep-07
Jan-08
May-08
Sep-08
Jan-09
May-09
Sep-09
Jan-10
May-10
Sep-10
Jan-11
May-11
Sep-11
(y-y %) (y-y %)IIP (LHS)
Sensex 12-m fwd P/E change (RHS)
The market has de-rated on
growth concerns
Indias market
underperformance relative to
major peers was stark in 2011
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Fig. 7: Slowing growth, high inflation and a much weaker rupee have causedsignificant underperformance of Indian equities compared to regional peers
Source: Bloomberg, Nomura researchNote: All equity market indices are USD-denominated
Understanding the slowdown - business cycle decomposition: One way to assess
the nature of the ongoing slowdown is to tease out the cyclical components of time
series of GDP by expenditure, to understand how consumption and investments have
fared, and by output, to understand how sectors have fared.
The aim of the exercise is two-fold: 1) to identify sectors that are leading the slowdown,
and 2) to determine the extent to which Indias long-term trend growth rate has declined
post-crisis. Aggregate economic time series are viewed as fluctuating around a longer-
term trend and deviations from trend are caused by seasonal and cyclical factors. The
cyclical fluctuations are caused by business cycle conditions, in turn determined by key
macroeconomic variables such as interest rates, inflation and exchange rate.
We worked with 50 quarters of GDP data, both from output and expenditure sides. For
each output series, we first deseasonalised the raw data and then used an HP-filter to
obtain the underlying trend and cycle components of the underlying seasonally adjusted
series. The Hodrick-Prescott filter is an empirical technique commonly used inmacroeconomics to decompose economic time series into trend and cyclical
components.
Trend growth rate of GDP has come off the pre-crisis highs: Trend growth rates
peaked around 2007 and have been on the decline since for most sectors, except for
agriculture (Exhibit below). This is not surprising for two reasons: (1) outright
contractions in economic activity and weak growth have plagued most countries post
crisis, and (2) Indias is a supply-constrained economy and the declining trend growth
rates are reflective these constraints.
Within sectors, the relative resilience of services stands out in contrast to the decline in
industry. The slowdown in industry has largely been driven by manufacturing and
construction; the decline in trend growth rates of electricity and mining output have been
relatively less pronounced. Agriculture has seen its trend growth rise since 2002. This
has been driven by: a fall in the volatility of farm output; rising area under irrigation; rise
in ancillary activities and income on the back of spill-over effects of higher overall
economic activity, wealth effects of rising land prices and higher farm support prices.
50
60
70
80
90
100
110
120
130
Dec-10
Jan-11
Jan-11
Feb-11
Mar-11
Mar-11
Mar-11
Apr-11
Apr-11
May-11
May-11
Jun-11
Jun-11
Jul-11
Jul-11
Jul-11
Aug-11
Aug-11
Aug-11
Sep-11
Sep-11
Sep-11
Oct-11
Oct-11
Oct-11
Oct-11
Nov-11
Nov-11
Nov-11
Dec-11
Dec-11
Dec-11
US EUR HK JAPAN
CHINA TAIWAN KOREA INDIA
SING INDO
(Base 31 Dec'10=100)
We employ business cycle
decomposition techniques to
understand the extent of the fallin trend growth rate of output
Regarding trend growth rates,
the relative resilience of services
stands in contrast to the declinefor industry
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The investment cycle has been a casualty of elevated cost of capital: Much as
elevated interest rates have taken their toll on overall GDP growth, the investment cycle
too has become a casualty of higher cost of capital and tight liquidity this past year (the
government has done its fair bit too, but more on that later). The exhibit below shows
that interest rates today strongly influence investment growth six months from now. The
relationship looks much like the one between non-agri GDP growth and interest rates
given that investments are about 34% of GDP.
Fig. 12: Growth in investments is strongly influenced by interest rates, with a lag of
about six months, similar to the lag observed between GDP growth and interest rates
Source: Business Beacon, Bloomberg, Nomura research
Digging deeper into investments
The outlook on the investment cycle depends on how its different subcomponents are
expected to behave this year. National income data are not very useful here, in our view,
because segment-wise details are only available with a lag. The latest figures for capital
formation by the corporate sector, government and households are available for up to
FY10. So the best we can do is to consider alternative data to piece together a coherentpicture of what has happened in each of these segments.
Divergent signals: This deep dive is also necessary to reconcile diverging signals in the
economy. The current slowdown has been characterised by slowing GDP growth and
expanding current account deficit. Another interesting dichotomy has been between
industrial growth and commercial vehicle sales. Despite poor growth numbers and very
high interest rates, commercial vehicle sales are growing steadily and have shown some
recent signs of strengthening.
We believe that the answer lies in how interest rates are affecting the economy. We think
that the corporate capex cycle has not yet slowed down meaningfully (even though new
project plans are getting shelved/delayed). Instead, the impact on rates has largely been
on household savings behaviour. This would explain a worsening of the current account
deficit in face of slowing growth.
High inflation and interest rates have caused a shift from housing construction to
gold: High inflation has in our view caused the erosion of domestic purchasing power of the
rupee and prompted a switch to alternative avenues like gold. High interest rates and
elevated property prices have reduced the affordability of housing. Importantly, expectations
have been increasing of an imminent fall in property prices amidst weakening domestic
sentiment arising from a growth slowdown. This has resulted in weak cement demand and
strong demand for gold imports, thereby depressing housing construction activitymore than
half of cement demand comes from private housing in the unorganised sector; slowdown in
government-led infrastructure would also be an important reason for slowdown in cement
demandand worsening Indias current account deficit. This hypothesis finds resonance in
cement despatch and gold imports data over the past two years which have been
characterised by high inflation and interest rates.
9
10
11
12
13
14
15
16(10)
(5)
-
5
10
15
20
25
Jun-00
Dec-00
Jun-01
Dec-01
Jun-02
Dec-02
Jun-03
Dec-03
Jun-04
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Jun-05
Dec-05
Jun-06
Dec-06
Jun-07
Dec-07
Jun-08
Dec-08
Jun-09
Dec-09
Jun-10
Dec-10
Jun-11
Dec-11
(yy %) (%)Fixed investment ,2-qtr lag (LHS)
Prime lend ing rate, inverted scale (RHS)
High interest rates and low
affordability of housing has
caused a decline in housing
construction and lowered
cement demand. The switch ofhousehold savings to gold has
widened the current account
deficit.
The current slowdown has
coincided with a widening of
current account deficit and
strong commercial vehicle sales
The investment cycle has been
a casualty of high rates and
slowdown in government-led
investment
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Fig. 13: High interest rates and inflation have caused a switch in household portfoliosaway from housing into gold. The encircled portion in the chart illustrates this.
Source: Business Beacon, Nomura research
Bank credit data provides further evidence of the slowdown in housing construction
which explains the fall in cement demand. This can be seen in the Exhibit below - the
share of housing in total non-food credit outstanding is at its lowest post crisis. Inaddition, credit data also show that FY12 has seen the lowest growth in housing credit
YTD, which is again consistent with slow cement demand growth.
Fig. 14: The share of housing in non-food credit outstandinghas declined in line with the slowdown in housing
construction activity and decline in cement demand
Source: RBI, Nomura research
Fig. 15: This is also visible in the slower expansion of creditto the housing sector, which has declined in FY12
Source: RBI, Nomura research
The corollary of this hypothesis is that as inflation shows signs of easing from here on,
and interest rates start coming off, households would reallocate their portfolios towardshousing away from gold. The fall in gold imports has already started happening, aided by
the sharp depreciation of the rupee; an acceleration of this trend would be a significant
positive for the current account deficit.
Momentum of execution in government-led projects has come off: Hamstrung
government decision-making has taken a toll on infrastructure projects owned and
sponsored by the government. We believe the outlook on this front is likely to remain
weak in the near term, given the fragile state of government finances. We discuss
government policy later in a separate section.
Corporate capex has not yet fallen meaningfully: We have reasons to believe that
corporate capex activity has not declined meaningfully yet and the slowdown would be a
gradual process. Evidence for our view comes from the following data:
0
2
4
6
8
10
12
14
(4,000)
(2,000)
0
2,000
4,000
6,000
8,000
Dec-02
Jun-03
Dec-03
Jun-04
Dec-04
Jun-05
Dec-05
Jun-06
Dec-06
Jun-07
Dec-07
Jun-08
Dec-08
Jun-09
Dec-09
Jun-10
Dec-10
Jun-11
(USDmn) (%)Gol d & silver imports (y-y chg ), 2qma (LHS)
Cement d espatches (y-y %), 2qma (RHS)
8.5
9.0
9.5
10.0
10.5
11.0
11.5
Nov
Jan-
Mar
Nov
Sep
Dec
Feb
Jul-10
Sep
Nov
Jan-
Mar
Aug
Oct-11
(%) Housing credit outstanding as % of total non-food credit
0
1
2
3
4
5
6
7
8
0
50
100
150
200
250
300
350
400
450
FY08 FY09 FY10 FY11 FY12
(INRbn) (%)Credi t expansion (Apr-Oct) (LHS)
% in crease (Apr-Oct) (RHS)
Credit expansion to the housing
sector in FY12 fell to its lowest
in five years
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Commercial vehicle sales are still strong: The strength in commercial vehicle sales
belies a significant weakening of corporate capex. Sales came off sharply in the period
immediately during the crisis period in late 2008. However, CV sales on an annual
basis have been inching upwards and came in at above 42% y-y in November. There
are no base effects at play either.
Fig. 16: The strength in commercial vehicle sales belies a significant weakening ofcorporate capex. Annual growth rate of CV sales has been rising and came in above42% y-y in November
Source: SIAM, Nomura research
Capital goods imports have been surprisingly resilient: Another reason to suspect that
capex activity has not yet weakened meaningfully is that capital goods imports still look
elevated. On a monthly basis, imports peaked in May-11 and have started to come off a bit.
We expect imports to fall further from these levels to reflect the ongoing slowdown in growth
and weakening order inflows. This would be positive for the current account deficit.
Fig. 17: Capital goods imports still look elevated and should fall from current levels toreflect the slowdown in growth
Source: Business Beacon, Nomura research
Sales growth of capital goods companies have held up well: The Exhibits below
shows sales growth of three categories of companies in the BSE500 index: a) Capital
goods (a proxy for the corporate capex cycle); b) real estate (proxy for housing); and c)
construction ex L&T (proxy for government-related capex spends).
As the exhibits below show, capital goods companies sales growth has remained
surprisingly resilient while both real estate and construction companies have seen a
significant fall off in their growth trajectories. This supports the supposition that the
(100)
(50)
0
50
100
150
200
250
Jan-08
Mar-08
May-08
Jul-08
Sep-08
Nov-08
Jan-09
Mar-09
May-09
Jul-09
Sep-09
Nov-09
Jan-10
Mar-10
May-10
Jul-10
Sep-10
Nov-10
Jan-11
Mar-11
May-11
Jul-11
Sep-11
Nov-11
(y-y %) CV (s.a.)
0
1,000
2,000
3,000
4,000
5,000
6,000
Jan-04
Apr-04
Jul-04
Oct-04
Jan-05
Apr-05
Jul-05
Oct-05
Jan-06
Apr-06
Jul-06
Oct-06
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Apr-08
Jul-08
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Apr-11
Jul-11
(USDmn)
The strength in CV sales belies
a significant weakening of
corporate capex
Capital goods imports are still
elevated and should fall from
here
Sales growth of cap goods
companies is still resilient.Meanwhile, it has come off for
real estate and construction (ex-
L&T) companies
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slowdown in investment cycle is largely a function of slowdown in government spends
and household switching from physical assets to valuables for investments.
Fig. 18: Sales growth for capital goods companies are stillresilient
Source: Ace Equity, Nomura research
Fig. 19: Meanwhile, growth trajectories for construction (ex-L&T) and real estate companies have come off significantly
Source: Ace Equity, Nomura research
Future imperfect? Past momentum is no guarantee for the future: Forecasting the
trend of investments is made difficult by several important considerations:
Policy changes can reaccelerate the capex cycle: One big issue dogging new
investments is government policy. Environmental issues, land acquisition-related
uncertainties and general political and bureaucratic decision-making slowdown is
leading to slowdown in large ticket investments. While the current political environment
still remains poor, any changes on the positive side can lead to a pick up. Nevertheless,
looking at the current environment, we believe it is safe to say that 2012 would be a
very slow year for new projects.
A reversal in monetary policy should reaccelerate household investments in real
estate: As the monetary policy eases, we expect households to start allocating capital
away from valuables into physical and financial assets. However, significant easing is
required before this switch starts to happen. Given that RBI would have a lagged
response to fall in inflation, this phenomenon would take at least 9-12 months to fully
materialise.
Government finances would remain poor: Given the fiscal deficit overshoot, the
ability of the government to divert more resources into capital formation remains
extremely limited. Government was a big driver of capex cycle in the last five to six
years both at the state (roads, irrigation etc) and central level.
Corporate sector has money but needs better policy: On an overall basis, two basic
preconditions for a strong capex cycle: (1) unfulfilled demand (as evidenced by trade
deficit and shortages), and (2) financial ability to invest (as evidenced by aggregate
balance sheet strength of corporates) are not the constraining factor on capex. Thepolicy environmentmonetary, fiscal and pace of decision makingare the main
constraints. These may continue to remain unfavourable for some more time.
Global uncertainty adds to capex cycle slowdown: The chart below shows the
latest breakdown of capex of BSE500 companies by sectors. Telecom, oil & gas,
metals & mining and power are the four largest contributing sectors in overall capex. All
of these face some headwinds in terms of policy or the global environment. This means
that new projects in these sectors would remain quite slow. We note that the current
momentum in the capex cycle is driven by projects planned earlier and as the new
pipeline weakens, the capex cycle would continue to weaken prospectively.
0
5
10
15
20
25
30
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
Jun-09
Sep-09
Dec-09
Mar-10
Jun-10
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
(y-y %)
0
10
20
30
40
50
60
70
(100)
(50)
0
50
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Mar-08
Jun-08
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Mar-09
Jun-09
Sep-09
Dec-09
Mar-10
Jun-10
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
(y-y %) Real Estate (RHS)
Con struction ex L&T (LHS)
New capex activity would be
slow on policy issues, slow
government decision-making,
poor public finances adverse
political environment
Corporate balance sheetsappear strong and demand is
not an issue
New activity in big capex-driving
sectors face global uncertainties
and policy headwinds
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Fig. 20: Capex in oil & gas, telecom, power and metals & mining sectors constitutedclose to three-fourths of total capex by BSE500 group of companies in FY11
Source: Ace Equity, Nomura research
Fig. 21: Reasons for slowdown in incremental capex activity in the four big capex
sectors
Source: Nomura research
Bottom-line on capex only expect a lagged recovery: From the perspective of the
next twelve months, we believe that the following factors would weigh heavily on the
capex cycle:
Rates: Interest rates have risen significantly and we believe an easing of the cycle issometime away. Decisions on investments in new projects would clearly remain slow till
the time rates reduce to lower levels from here. This would mean that 2012 would be
weak for new orders.
Policy: Uncertainty on account of pending policy decisionsland acquisition bill, FDI in
retail, fuel-related policy etcwould continue to cast a shadow on investment
decisions. Additionally, the uncertain political environment also means that the
bureaucratic machinery would remain slow, slowing down fresh approvals.
Global environment: Till the time the European crisis does not abate, capital
availability would remain an overhang on the capex cycle.
The capex slowdown would manifest as: 1) slow new order momentum and 2) gradually
reducing sales growth of capital goods companies. As can be seen below, new order
inflows for a group of five companies that we cover (LT IN, IVRC IN, NJCC IN, HCC IN
and PUNJ IN) were down y-y in 2QFY12. This situation is likely to continue for some
more time.
Autos , 3.86%
Oil & gas ,22.71%
Infra & cap goods, 5.36%
Cement, 2.48%
Consumer,2.63%
Pharma, 2.23%
IT, 3.10%Power, 15.13%
Metals & mining ,15.86%
Telecom ,17.85%
Transport ,3.91%
Misc, 4.88%
Sector Reasons for slowdown in new capex activity
Oil and gas Slow decision making. Adverse policy environment
Metals Environment clearances, ban on mining and global slowdown would mean new
project activity would be slow
Telecom Significant policy uncertainty. Saturation of voice market
Power Fuel unavailability
Expect only a lagged recovery in
capex
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Fig. 22: New order inflows for infra & construction companies under our coveragewere down y-y in the Sep-qtr. The slowdown in new orders is expected to continue
Source: Nomura research
The rupee: capital flows and eurozone concerns
The unexpected weakening of the rupee has presented fresh challenges for the
economy in form of 1) higher deficit on account of oil subsidies; 2) inflation stickiness; 3)
strain on servicing foreign loans; and 4) dilution of investor returns in dollar terms. We
believe that Indias rupee weakness, which in the first phase has been attributed to its
large current account deficit and European crisis, would persist for some time. Even
though we believe that the current account would improve from here, it would be the
capital account which would pose significant challenges to the rupee. These challenges
are likely to continue for the most part of 2012, following which rupee should start to rally,
in our view.
The unexpected appreciation of the dollar following the US sovereign downgrade
jolted the rupee initially: The rupees decline in began in August last year and
coincided with the unexpected flight-to-safety-induced appreciation of the USD followingthe S&Ps sovereign downgrade of the US. We suspect the first leg of rupees fall was
prompted by a rush to cover unhedged short USD positions and was not driven by FII
selling FIIs had bought net USD305mn in equities and sold net USD15mn in bonds in
September and October, even as the rupee had moved from INR46.1 to INR48.7
through these two months . The rupees decline was not in isolation and was joined by
other high-beta Asian currenciesIndonesian rupiah (IDR) and Korean won (KRW)as
can be seen in the Exhibit below.
80
100
120
140160
180
200
220
1QFY09
2QFY09
3QFY09
4QFY09
1QFY10
2QFY10
3QFY10
4QFY10
1QFY11
2QFY11
3QFY11
4QFY11
1QFY12
2QFY12
Order inflows for infra & construction companies(Base 1QFY09 = 100)
The capital account would be a
cause for concern this year
while the current account
concerns would likely improve
The unexpected appreciation of
the USD following the US
sovereign downgrade in Augustjolted high-beta Asian
currencies; the INR
underperformed significantly
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Fig. 23: The global risk event triggered by the US sovereign downgrade brought high-beta Asian currencies under pressure; however, the rupees underperformance has
been stark
Source: Bloomberg, Nomura research
Twin deficits, high inflation and lack of RBI support: However, once the flood gates
had opened and the rupee breached established trading ranges, the rupee found itselfunder severe and unrelenting pressure as market expectations of continued rupee
weakness were getting increasingly broad-based. The rupee underperformed the KRW
and IDR in the following period and two factors accelerated its underperformance: (1)
Indias economic fundamentals were distinctly poorer, underpinned by its twin current
account and fiscal deficits (Exhibit below) and high inflation that had led to severe
erosion of the rupees domestic purchasing power, and (2) the RBI did not publicly state
its intention to support the rupee; how successful the RBI would have been in defending
the rupee, had it chosen to do so, is another matter.
Fig. 24: The rupees weakness was underpinned by Indias
high current account deficit
Source: Nomura Global economics
Fig. 25: and a high fiscal deficit
Source: Nomura Global economics
The rupees sharp decline and expectations of further weakness, amidst heightened risk
aversion on account of the eurozone debt crisis, induced aggressive forward covers by
hedgers, accompanied by fair bit of speculation, we reckon. The sharp appreciation of
the USD in off-shore forwards across maturities has reflected the rise in forward
premiums in the on-shore forward market and depreciation of the rupee in the spot
market.
Uncertainty regarding the rupee is near an all-time high: We are all too aware of the
hazards of making point forecasts of exchange rates and make no attempt to do so here,
95
100
105
110
115
120
125
Aug-11
Sep-11
Oct-11
Nov-11
Jan-12
INRUSD IDRUSD KRWUSD
(Base 100=1 Aug'11)
(4)
(3)
(2)
(1)
0
1
2
3
CY2011E CY2012E CY2013E
India Korea Indonesia
(%)
(6)
(5)
(4)
(3)
(2)
(1)
0
1
CY2011E CY2012E CY2013E
India Korea Indonesia(%)
The INR underperformed its
peers given its high currentaccount deficit and inflationproblem
Currency options markets are
suggesting a high sense ofuncertainty about where therupee will find support
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especially during these times of high global uncertainty. The implied volatility of the
rupee, based on at-the-money USDINR currency options, is closet to all-time highs and
makes it difficult to say with any degree of certainty about where the rupee would find
support in the near term (Exhibit below). A quick back-of-the-envelope calculation based
on the current implied volatility of at-the-money currency options suggests that there is a
90% chance that the rupee could be trading between 42 and 63 by the end of the year
a very wide range, indeed.
Fig. 26: The average implied volatility of the rupee based on currency option contractsis close to its highs, reflecting the overall sense of uncertainty regarding the rupees
trajectory
Source: Bloomberg, Nomura research
In our view, the rupees near-term fate is contingent on how severe deleveraging
concerns on eurozone banks become: The outlook for the rupee in the near term
would be conditioned by how the European debt crisis evolves. It is fair to say that the
rupee would struggle to stabilize to pre-August levels so long as the eurozone is under
strain, global risk aversion is high and concerns on capital flows to India persist. It can be
seen from the relationship between CDS spreads for European banks and INR/USD ratethat the rupees depreciation since August has much to do with the risk flare-up in
eurozone banks.
Europe is largely an exogenous parameter, but one that will have a significant bearing on
the rupee in the coming months. Our working assumption for the near term is one in
which European banks would most likely remain under deleveraging pressure and shore
up their capital positions in the face of funding pressures from debts maturing this year
and more stringent Basel III norms coming into effect next year. As the global reserve
currency, the excess demand for dollars that would arise should deleveraging concerns
in the eurozone exacerbate in the coming months is the key risk to the rupees
performance, we think. The RBI, in its December Financial Stability Report estimated the
consolidated claims of European banks on India at 8.6% of Indias nominal GDP.
4
6
8
10
12
14
16
Aug-11
Sep-11
Oct-11
Nov-11
Dec-11
USDINR 1m Imp Vo l USDINR 3m Imp Vo l
USDINR 6m Imp Vol USDINR 1yr Imp Vo l
(%)
Deleveraging concerns in
Europe are an overhang on the
rupee in the short-term
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Fig. 27: The rupees sharp decline since August has been driven by deleveraging risksfacing eurozone banks
Source: Bloomberg, Nomura research
Refinancing and redemption pressures: While developments in Europe would set
the risk appetite for global capital, the rupee, in addition, would have two key
overhangs to contend with as we make our way into 2012.
A big chunk of the large external commercial borrowings (ECBs) by Indias corporate
sector during 2006-07 is coming up for redemption this year. The figure below plots
gross inflows of ECBs against gross outflows lagged by 5 years (this conforms to the 3-
7 year maturity of an average ECB loan). We estimate that about USD30bn worth of
ECB loans would have to be dealt with by corporates they would have to either be
repaid or rolled over. If the risk backdrop is mild then most of these loans would have a
good chance of being repaid or refinanced, albeit at higher interest rates. Anecdotal
evidence suggests that about 30% of ECB payments are hedged; this figure would
likely have increased in light of the recent sharp depreciation of the rupee. If this were
the case, then downward pressure on the rupee would likely be contained to the extent
corporates have already immunised themselves by taking adequate forward covers. To
the extent that this is not the case, the excess demand for dollars would imply further
rupee weakness. In either case, this uncertainty in itself would likely keep the rupees
outlook volatile.
40
42
44
46
48
50
52
54
56
0
100
200
300
400
500
600
May-09
Jun-09
Jul-09
Jul-09
Aug-09
Oct-09
Nov-09
Dec-09
Dec-09
Jan-10
Feb-10
Mar-10
Apr-10
May-10
Jun-10
Jul-10
Aug-10
Sep-10
Oct-10
Nov-10
Dec-10
Jan-11
Feb-11
Mar-11
Apr-11
May-11
Jun-11
Jul-11
Aug-11
Sep-11
Oct-11
Nov-11
Dec-11
(bps) Euro ban ks 5y r CDS (LHS) INRUSD ( RHS)
Close to USD40bn of ECBs and
FCCBs need to be refinanced or
redeemed in 2012
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Fig. 28: Large external commercial borrowings taken on by the Indian corporate sectorfive years ago are going to come up for redemption this year
Source: Bloomberg, Nomura research
Another source of concern for the rupee and sentiment, although not as large in terms
of absolute numbers as ECBs, is redemptions of FCCBs (foreign currency convertible
bonds). With current stock prices much below conversion prices, near-certainredemptions of FCCBs are another overhang on the rupee. The exhibit below breaks
down the amounts outstanding by year 2012, with about USD7bn (mostly in the first
nine months of the year) would be when most of these bonds would have to be
redeemed.
Fig. 29: Upcoming FCCB redemptions peak in 2012 and then taper off after that
Source: Nomura research
Fundamentally speaking, inflation differentials are on the way down: Even as risk
aversion and concerns on capital flows are l ikely prevent a quick reversal of the rupee in
the near term, the rupees outlook over the year is supported by improving fundamentals
rate differentials are likely to stay high, and the sharp depreciation of the rupee so far
would likely begin to show up as a contraction of the current account deficit.
A country with an inflation problem is most likely to see its currency depreciate. High
relative inflation reduces real rate differentials, while the erosion of domestic purchasing
power of its currency spills causes an erosion of its purchasing power externally. The
Exhibits below show that this has largely been the case for the INR/USD exchange rate.
Seen in this context, the rupees decline is not altogether surprising.
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
Jun-90
Mar-91
Dec-91
Sep-92
Jun-93
Mar-94
Dec-94
Sep-95
Jun-96
Mar-97
Dec-97
Sep-98
Jun-99
Mar-00
Dec-00
Sep-01
Jun-02
Mar-03
Dec-03
Sep-04
Jun-05
Mar-06
Dec-06
Sep-07
Jun-08
Mar-09
Dec-09
Sep-10
Jun-11
ECB gross inflows
ECB gross outflows (lagged 5 years)
(USDmn)
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
CY2012 CY2013 CY2014 CY2015
(USDmn)
Falling inflation differentials and
contraction in current accountdeficit should emerge as
fundamental tailwinds for the
rupee later this year
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Fig. 35: Headline inflation and its subcomponents have stabilised at unacceptably highlevels post crisis
Source: Business Beacon, Nomura research
Downward sticky inflation is anathema to any central bank because it sets the stage for
inflation expectations to be high too given that expectations of future inflation are formed
adaptively individuals base their investment, savings and consumption decisions basedon past inflation. The RBIs natural response has been to progressively raise policy rates
and, in conjunction with its aggressive anti-inflationary stance, keep systemic liquidity at
tight levels (see figure below).
Fig. 36: Rising inflation has resulted in significant tightening of policy rates and tight
systemic liquidity
Source: Bloomberg, Business Beacon, Nomura research
High interest rates and an anti-inflationary policy stance, amidst weakeningeconomic activity, have kept liquidity tight and led to fall in growth rate of the
monetary base: Progressively higher interest rates since mid-2010 have caused the
opportunity cost of money to rise. This has resulted in a switch from currency holdings
and demand deposits to higher-yielding term deposits, causing the rates of growth of M1
and M3 to sharply diverge (see figures below). The extent of the fall in the transactionary
demand for money suggests a much reduced amount of economic activity. The growth
rate of the monetary base has come off significantly on the back of the fall in currency-in-
circulation and because the RBI did not inject meaningful primary liquidity into the
economy by way of open market operationsOMOs (open market operations) have
picked up since end of Nov-11in keeping with its anti-inflation stance.
(15)
(10)
(5)
0
5
10
15
20
25
May-05
Aug-05
Nov-05
Feb-06
May-06
Aug-06
Nov-06
Feb-07
May-07
Aug-07
Nov-07
Feb-08
May-08
Aug-08
Nov-08
Feb-09
May-09
Aug-09
Nov-09
Feb-10
May-10
Aug-10
Nov-10
Feb-11
May-11
Aug-11
Nov-11
WPI Prim articles
Mfg prods Fuel & power
(%)
(1,500)
(1,000)
(500)
0
500
1,000
1,500
(2)
0
2
4
6
810
12
14
Feb-02
Jun-02
Oct-02
Feb-03
Jun-03
Oct-03
Feb-04
Jun-04
Oct-04
Feb-05
Jun-05
Oct-05
Feb-06
Jun-06
Oct-06
Feb-07
Jun-07
Oct-07
Feb-08
Jun-08
Oct-08
Feb-09
Jun-09
Oct-09
Feb-10
Jun-10
Oct-10
Feb-11
Jun-11
Oct-11
(%) (INRbn)Net LAF balance (RHS)
Repo rate (LHS)
WPI (y-y) (LHS)
Weakening economic activityand high inflation have reduced
transactionary demand for
money and caused a shift tohigher-yielding term deposits
and gold
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Fig. 37: High inflation has been met by rising interest rates.The higher opportunity cost of money has caused a sharp
divergence between M1 and M3 rates of growth
Source: Business Beacon, Nomura research
Fig. 38: which has been driven by a switch from currencyin circulation and demand deposits to higher yielding time
deposits
Source: Business Beacon, Nomura research
High gold imports have worsened Indias external position and put pressure on
the rupee: In addition to prompting a reallocation of household savings towards higher-
yielding term deposits, the erosion of the rupees domestic purchasing power has also
caused a shift towards physical forms of savings, i.e. gold. The resulting fall in the supply
of loanable funds in the economy has put incremental pressure on interest rates. This
switch to gold has come at the expense of housing construction activity and has caused
a notable divergence between cement demand, which has been weak, and gold imports,
which touched record levels earlier this year.
The figure below shows the relationship between Indias gold & silver imports and WPI
inflation. Indias WPI basket is commodity-heavy and changes in global commodity
prices could drive the mutual relationship between gold prices (and hence nominal
imports) and inflation. To account for this, we plot real gold imports (by deflating nominal
gold imports by gold prices) against inflation, and find that the relationship holds up well
on average. This increase in gold imports has put considerable pressure on the rupee
through the trade route. This has happened in the backdrop of a fragile global risk
environment and elevated concerns on capital flows. Also, the fall in real rate differentials
because of rising inflation differentials has further weakened the rupees case. However,
after adjusting for valuables in both merchandise imports and exports data, we find that
trade and current account deficits would have appeared much more manageable.
Fig. 39: Gold provides a hedge against high inflation
Source: Bloomberg, Business Beacon, Nomura research
Fig. 40: Strong gold imports have worsened Indias externalposition. Trade and current account deficits appear less
alarming after adjusting for valuables
Source: Business Beacon, Nomura research
0
5
10
15
20
25
30
Oct-00
Mar-01
Sep-01
Mar-02
Sep-02
Feb-03
Aug-03
Feb-04
Jul-04
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jun-07
Dec-07
Jun-08
Dec-08
Jun-09
Dec-09
Jun-10
Dec-10
Jun-11
Dec-11
(y-y %) M1 M3
(20)
(10)
0
10
20
30
40
50
Jan-04
May-04
Oct-04
Mar-05
Aug-05
Jan-06
Jun-06
Nov-06
Apr-07
Sep-07
Feb-08
Jul-08
Dec-08
May-09
Oct-09
Mar-10
Aug-10
Jan-11
Jul-11
Dec-11
(y-y %) Currency
Demand deposits
Time deposits
(1)
1
3
5
7
9
11
13
20
40
60
80
100
120
140
Jun-05
Oct-05
Feb-06
Jun-06
Oct-06
Feb-07
Jun-07
Oct-07
Feb-08
Jun-08
Oct-08
Feb-09
Jun-09
Oct-09
Feb-10
Jun-10
Oct-10
Feb-11
Jun-11
Oct-11
(Base 100=Apr'05) (%)
Real go ld imports index, 3mma (LHS)
WPI, 3mma (RHS)
(20)
(15)
(10)
(5)
0
5
Mar-07
Jun-07
Sep-07
Dec-07
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
Jun-09
Sep-09
Dec-09
Mar-10
Jun-10
Sep-10
Dec-10
Mar-11
Jun-11
Trade balanceCABTrade balance ex-valuablesCAB ex-valuables
(As % of GDP)
The strong pick-up in gold
imports has put pressure on the
external position and the rupee
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Valuations not demanding and are pricing in a significantcut to earnings, but waiting for triggers
What has gone wrong with the Indian market in the last few months?: When we
became more constructive on the market in June-end last year, our view was driven by
slowing inflation momentum and a consequent lagged drop in interest rates, which would
have led to firming up of markets. Subsequently, the European situation flared up starting
August, which in more ways than one has delayed market recovery. First, the weakening of
external demand has delayed the recovery of the current account. Second, the rupee has
underperformed significantly in the last five months as capital flows have turned weaker.Third, this has pushed back the anticipated fall in inflation. Fourth, the fall in the rupee has
exacerbated the fiscal situation and has led to higher oil and fertiliser subsidies.
As we take a fresh view on the market this year, we think that a likely continuation of the
European situation means that the Indian economy would have to contend with adjusting its
growth downwards in order to deal with the weaker global situation. This is especially true in
view of Indias capital account which is going to remain under pressure for another twelve
months. We think a significant recovery is Indias external situation is a near certainty over
this period as a slowing economy would lead to a current account recovery and debt
repayments would whittle down to more manageable levels. In our view, the markets are not
discounting this recovery market multiples are now discounting the rate cycle to remain
elevated for a significantly longer period. However, between then and now, the path of the
market is less clear.
The market is trading at a reasonable discount to its long-rangeaverage: At current
levels, the market is trading at 12.0x 12-month consensus-based forward earnings, which
translates to a 23% discount to its five-year average. At these levels valuations appear to be
discounting a significant cut to earnings and further downside to economic growth.
Fig. 47: The market is trading at a reasonable discount to its 5-yr average
Source: Bloomberg, Nomura research
and could get cheaper with respect to bonds if inflation comes off: Additionally, with
respect to bonds, we think equity valuations are beginning to look a lot more attractive, as can
be seen in the Exhibit below, which plots the Sensex earnings yield vs. the 10- year
government bond yield.
Bond yields have come off from their highs of Nov-11 on the back of growth concerns and
expectations of the next move by the RBI to be a cut in rates; OMO support by the RBI also
aided the decline in bond yields. Although inflation has in a way been hijacked by the sharp
depreciation of the rupee, food inflation has started to decline, leading to tempering of inflation
expectations. Manufactured products inflation should begin to react to the ongoing slowdown
in growth and a tepid outlook for global commodity prices in the face of slow global growth
expected in 2012 and a likely stronger dollar amidst elevated risk aversion emanating from
ongoing eurozone debt problems. Any major downside surprise in inflation could easily push
equities into relatively cheap territory quite quickly, in our view.
4
9
14
19
24
29
34
Apr-97
Oct-98
Mar-00
Sep-01
Feb-03
Jul-04
Dec-05
Jun-07
Nov-08
May-10
Oct-11
Sensex 12-m fwd P/E
5-year average = 15.5x
Market multiples are pricing in a
significant cut to earnings,further downside to economic
growth and an elevated rate
cycle
Valuations would start looking
more attractive as inflation
eases and bond yields fall
Our change in view on the
market in end-June was
hijacked by the global risk flare
up and the ensuing rupee
weakness
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Clouded first half, better second half: Of the four macro variables mentioned above,
there is little visibility of improvement in the immediate future. Market multiples have
already adjusted downwards to account for lower growth and high interest rates. To that
extent, we believe that the downside to the markets is limited as interest rates should
start to come down, albeit with a delay. The path to recovery would be rather clouded as
the news flow would improve only with a lag.
Earnings expect some downside to FY13F earnings
Earnings have been cut by 10-12% over the past 12 months: In Dec-10, we had
argued that prospects for corporate profitability in 2011 would be shaped by a tough
macroeconomic environment and saw downside risk to consensus earnings growth
expectations of 20% for FY12F. The Exhibit below shows the evolution of FY12F and
FY13F consensus earnings for the Sensex over the past 12 months. Given the
reasonably strong economic environment through FY10, consensus earnings
expectations were stable until the early part of 2011. Since then we have seen consistent
consensus earnings downgrades. Earnings have been cut by 10% for FY12F and by
12% for FY13F, much in line with our expectations and consistent with the deterioration
in the macroeconomic environment in the latter part of 2011.
Fig. 50: Consensus earnings have fallen significantly over the past year
Source: Bloomberg, Nomura research
with a tough macro backdrop for earnings: At the beginning of 2011, the prospect
for earnings for the year appeared subpar to us signs of increasing tightening of
liquidity, sticky inflation, an inflation-focussed RBI (policy rates were hiked by 225 bps in
2011) and rising cost pressures from global commodities portended a tough
macroeconomic backdrop for corporates in the year ahead. It was after the sovereign
risk flare-up in the later part of 2011 that prompted serious downgrades of earnings by
consensus, aided by policy-led slowdown in the investment cycle. The sharply
depreciating rupee in the last quarter and the all-around growth-pessimism prompted yetanother round of downgrades after Oct-11. Readings on industrial production, which had
been hovering around an average of 7.5% in the 1HCY11, took a decided turn for the
worst in the second half of the year and added further pressure on FY12F and FY13F
earnings estimates.
Expect FY13F Sensex earningsgrowth of around 10-12%: We think the trajectory for
earnings in 2012 would likely slow. Earnings could see some more risk as the economy
feels the lagged impact of the rate tightening cycle; the Exhibit below shows the leverage
of corporate earnings to growth. We reckon another couple of quarters of growth
slowdown as the effect of tight credit plays out with a lag. This would likely translate into
weakening earnings growth in the first half of the year. We also note that there are
headwinds to earnings growth from adverse base effects in the first half of FY13F as
earnings slowdown worsened in the second half of FY12.
86
90
94
98
102
Dec-10
Feb-11
Mar-11
May-11
Jun-11
Aug-11
Sep-11
Nov-11
Dec-11
SENSEX Earning s Index FY12
SENSEX Earning s Index FY13
(Base 100 = Dec'10)
Consensus earnings have beencut 10-12% over the past year
The macro environment turned
decidedly tough for earnings in
2H11
See downside risk to earnings
growth in 1H of this year. As
well, there are adverse base
effects to contend with.Pressures should subside in
later part of the year
There is limited visibility the in
near-term. The second-half of
the year looks better
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Fig. 52: Margin pressures on account of higher commodity prices might persist foranother 3-6 months. The benevolent effect of weakening global commodity prices was
offset by the sharp depreciation of the rupee
Source: Ace Equity, Bloomberg, Nomura research
Note: BSE100 ex-oil & gas and banks
Revenue growth has benefited amidst high inflation and strong pricing power ofcorporates: Revenue growth has surprised positively this past year. Corporate top-lines
have been resilient even as profits have been weak. One explanation for this could that
firms have enjoyed strong pricing power on an overall basis and have been able to pass
along rising input costs. This is not entirely surprising given that Indias is a supply-
constrained economy and is probably characterised by excess demand at a given price
level. Another reason for the strength in net sales growth is that manufactured product
prices still remain high because the global commodity complex and aggregate demand
have not collapsed like they did during the crisis period.
Fig. 53: Revenue growth bears a close relationship with inflation on average,suggesting that corporates have reasonably strong pricing power
Source: Ace Equity, Bloomberg, Nomura research
Note: BSE100 ex-oil & gas and banks
Overall, we expect 10-12% earnings growth in FY13F: Based on assumptions on
domestic and global growth, inflation and global commodity prices, we estimate FY13F
Sensex earnings growth of 10-12%.
(40)
(30)
(20)
(10)
0
10
20
30
40
50
(10)
0
10
20
30
40
50
60
Mar-02
Sep-02
Mar-03
Sep-03
Mar-04
Sep-04
Mar-05
Sep-05
Mar-06
Sep-06
Mar-07
Sep-07
Mar-08
Sep-08
Mar-09
Sep-09
Mar-10
Sep-10
Mar-11
Sep-11
(y-y %) (y-y %)COGS1qtr l ag (LHS) CRB (RHS)
(2)
0
2
4
6
8
10
12
14
(10)
0
10
20
30
40
50
60
Mar-0
2
Sep-0
2
Mar-0
3
Sep-0
3
Mar-0
4
Sep-0
4
Mar-0
5
Sep-0
5
Mar-0
6
Sep-0
6
Mar-0
7
Sep-0
7
Mar-0
8
Sep-0
8
Mar-0
9
Sep-0
9
Mar-1
0
Sep-1
0
Mar-1
1
Sep-1
1
(y-y %) (y-y %)Net sales (LHS) WPI (RHS)
Expect FY13F Sensex earningsgrowth of 10-12%
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Policyand political economy a clouded picture
A tough year for the government: 2011 was a tough year for the economy from the
policy environment point of view. The aftermath of the 2G scandal put the incumbent
government in a relatively weaker position. Parliament sessions have been largely
dysfunctional; attempts at pushing through reforms, such as pension bill and FDI in retail
have been blocked by allies of the ruling coalition. The anti-graft movement has slowed
down decision-making across government levels. We do not have high hopes from the
government on an overall basis for the rest of its term.
UPA, in general, is not a reformist government: We do note that the reform processunder the present government has always been weak lack of reforms has been an old
issue, not a new one (please see Appendix).
Why has the perception on policy making plunged to new depths then? First, it is due to
the policy paralysis and weakness set into motion as corruption scandals unfolded over
the course of the past year. Second, in part it is due to the governments inability to
control its finances, which is keeping interest rates at high levels. Third, the RBIs
tightening, which has slowed down the economy, is also getting blamed on governments
policy actions as the necessity of raising rates is considered, to some extent, as cleanup
action post fiscal mess of government finances.
We think there are two fundamental issues that are impacting the policy environment in
India:
Fragmentation of mandate: Post the 1991 Mandal Commission (reservations), caste
dynamics became a very important driver of Indian politics. This essentially led to
fragmentation of politics at state levels. The result of this has been constant
marginalization of national parties at the expense of local parties. Additionally, since the
agenda at state levels tends to be more populistas recently seen in TMCs opposition
to the governments moves to hike fuel prices, raise retail FDI and pass pension
reformthe national agenda tends to get diluted.
Fig. 54: Fragmentation of Indian politics
Source: Nomura research
Governance and politics: The second issue with the present government is the split
nature of power sharing at the center. UPA-I saw creation of the National Advisory
Council (NAC) which advises the prime minister on policy. NAC is headed by the
President of the Congress party, Ms. Sonia Gandhi, and its other members usually
consist of several social activists. NAC is largely responsible for populist schemes such
as National Rural Employment Guarantee Act (NREGA) and is now pushing for the
Food Security Bill. NACs suggestions have led to a significant increase in social
spending, which has led to a structural increase in the fiscal deficit.
Another issue is about authority of the prime minister. In all governments formed earlier,
prime ministers are typically politicians who are also de facto leader of political parties.
Thus there has been a separation of governance from politics which by nature of
Year
Dominant
party
No. of
seats
2nd biggest
party
No of
seats
Top party/total
seats
Top 2
parties/total
seats Remarks1971 INC 352 CPM 25 68% 73%
1977 BLD 295 INC 154 54% 83% Bhartiya Lok Dal - transitory party which won power as a
result of emeregency related pushback (Janta Dal)1980 INC 353 JNP (S) 41 65% 73% Janata Dal declined and Congress came back to power
1984 INC 404 BJP 2 79% 79%